- While there are reasons to get optimistic on the pound, Brexit negotiations remain the key driver
- Tangible results from the ongoing discussions are limited, creating significant uncertainty
- Following today's (likely) rate hike, focus will shift back to the discussions
The term ‘uncertainty’ has been used to describe the pound ever since the UK voted to leave the European Union. Despite the fact that one and a half years have passed since the vote, the outlook for the pound remains deeply uncertain. Looking at the pound in recent history, the currency has been mostly trading in a range. While it has strengthened from its lows earlier this year, the currency is not trending in any obvious direction today.
Some reasons for optimism, but mostly overshadowed by Brexit
While better-than-expected GDP growth, rate hike expectations and calmer domestic politics are genuine reasons to get optimistic about the pound, the currency is ultimately overshadowed by the Brexit negotiations. Tangible progress from the discussions remains limited, casting significant uncertainty regarding the future.
This is because the outcome of the discussions will have a significant impact on the UK and remains a binary event. If negotiations succeed, the pound is likely to strengthen once the terms of a Brexit deal become clearer. Businesses and investors are reluctant to invest in the UK today, given the lack of clarity on the future. A Brexit deal would immediately remove the current uncertainty, helping the economy recover in the future. The caveat here is that the deal would have to be beneficial for the UK for the pound to benefit. If the deal imposes significant costs on the country without the corresponding benefit, the currency market may instead drive the pound lower.
On the other hand, the pound is likely to fall sharply if there is no deal (or ‘hard Brexit’). While a ‘no deal’ scenario would arguably eliminate uncertainty, it would raise the costs of doing business with the Eurozone. Given the importance of UK-based firms that engage in cross-border financial and professional services (services is a big part of the UK economy), the currency is likely to suffer as a result.
Today’s hike looks priced in, but pound likely to remain under spell of Brexit
Given that the market’s odds for a Bank of England rate hike is above 85%, the pound is unlikely to benefit from today’s interest rate decision. In short, the rate hike looks fully fairly priced in. Following Governor Mark Carney’s comments stating that the “that global r* (equilibrium interest rates) may be rising, meaning that monetary policy has to move [up] in order to stand still”, few expect the Bank of England to embark on a longer-term path of normalizing interest rates.
Instead, expectations are high for a ‘dovish hike’, where Carney reduces expectations for future hikes after initially hiking. Similar to other central bank events, this is probably another instance of ‘buy the rumor, sell the news’. There’s also the small probability that Governor Mark Carney fails to pull the trigger entirely, choosing to hold rates steady. In this scenario, expect the pound to weaken substantially as the market is caught offside.
Despite the current focus on monetary policy, the strongest driver behind the pound remains Brexit. Following the Bank of England event later today, we expect the focus to once again shift to the disappointing pace of the current talks.